The sources of firms’ success

Colin Hottman, Stephen Redding, David Weinstein 14 October 2014

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Why are some firms larger than others? Some companies, such as the Coca-Cola Corporation, generate billions of dollars of sales and dominate the markets in which they operate. Other companies account for only a small fraction of the sales of their larger competitors. What accounts for these vast differences in firm performance?

Answering this question is important for quantifying equilibrium models of firm heterogeneity developed in the recent trade and macro literatures and for understanding the relationship between microeconomic firm performance and macroeconomic outcomes. Recent research on firm heterogeneity in trade and macroeconomics (e.g. Melitz 2003, Feenstra 2014, Manova and Zhang 2012) points to four components of firm heterogeneity: Costs, quality, markups, and product scope (i.e., the number of products produced by firms). Unfortunately, the state of the economics literature in understanding the role played by these factors in determining firm size is akin to the state of the productivity literature before Solow (1957); we know what forces matter for firm size, but we have no general and easily implementable accounting framework for understanding the sources of these differences.

Recent research on sources of firm success

In Hottman et al. (2014), we develop a structural model that can be used to decompose the firm-size distribution into the relative contributions of each of these components. We implement our model-based decomposition for the just over 50,000 firms that supply goods with barcodes in the Nielsen HomeScan Database in a typical quarter. This decomposition enables us to isolate different margins in the data without making assumptions about how these margins are related to one another (as in the business cycle decomposition of Chari et al. 2007 in the macroeconomics literature). Our framework requires only price and expenditure data and, hence, is widely applicable.

Our results point to quality differences, which we define as average consumer utility per physical unit of output, as the principal reason why some firms are successful in the marketplace and others are not.

  • Depending on the specification considered, we find that 50-70% of the variance in firm size can be attributed to differences in average product quality, about 23-30% to differences in product scope, and less than 24% to cost differences.

When we turn to examine time-series evidence, the results become even starker. Virtually all firm growth can be attributed to quality improvements, with most of the remainder due to increases in scope.

  • Since variation in product scope (e.g., adding products with new flavours or colours) can be thought of as a form of quality improvement, our results imply that quality, broadly defined, is the chief determinant of firm sales.

These results suggest that most of what economists call differences in revenue productivity reflect differences in quality rather than cost. The intuition is straightforward. The key insight is that marginal cost only affects firm sales through price, but quality is a demand shifter that shifts sales conditional on price. Since the data strongly suggest that firm size hardly varies at all with price – Coca-Cola doesn’t sell a lot because it’s a cheap soda – it must be quality differences that drive market shares.

Our analysis also makes clear a conceptual problem in the estimation of firm productivity that is likely to bias existing estimates. Most productivity estimates rely on the concept of real output, which is calculated by dividing nominal output by a price index. However, the formula for any economically motivated price index is dependent on implicit assumptions about how firm output enters utility. This economic concept is what underlies the common notion that a price index should weigh goods more if consumers purchase a lot of them, i.e., price indexes should weigh more heavily goods that consumers care about. Thus, one cannot move from nominal output to real output without imposing assumptions about the structure of the demand system.1

Our results show that a multiproduct firm's price is highly sensitive to how differentiated its output is and how many products it supplies.

  • Since larger firms tend to produce more products, conventional price indexes tend to overstate the price level of their output relative to small firms.

We can obtain some intuition for this by considering a simple example. Imagine all cans of soda cost $1. If Coca-Cola were now to only sell one type of soda, consumers would surely be worse off even if the remaining can still sold for a dollar. This reduction in variety should increase the prices because when a firm produces fewer products it has the same effect as raising the prices of some of its products so high that no one is willing to buy them.

This example makes clear that the right way to measure the price of Coke products is not to just use an average or representative price but a price that makes an adjustment for the variety of products sold. Holding prices fixed, if Coke sells more types of products, the utility consumers get from drinking Coke products, and therefore Coke’s real output, must rise. The positive association between firm size and product scope means that conventional measures of real output will have a downward bias that rises with firm size with an elasticity of around one third. In other words, real output variation is substantially greater than nominal output variation. This bias also implies that true productivity differences are much larger than conventionally measured productivity differences.

Our framework also provides a new metric for quantifying the extent to which a firm's products are differentiated from those of its rivals. If a firm's products are perfectly substitutable with each other but not with those of other firms, then 100% of a new product's sales will come from the firm's existing sales, which implies a cannibalisation rate of one. However, if a firm's market share is negligible (as it is for most firms) and its products are as differentiated from each other as they are from products supplied by other firms, none of a new product's sales will come at the expense of the firm's other products, which implies a cannibalisation rate of zero. We estimate substantially higher elasticities of substitution between varieties within firms than between firms (median elasticities of 6.9 and 4.3, respectively).

  • We show that the implied cannibalisation rate for the typical firm is about 50%, indicating that although products supplied by the same firm are more substitutable with each other than with those of other firms, it is not correct to think of them as perfect substitutes.

We find that the monopolistic competition benchmark of atomistic firms with constant markups provides a good approximation for the vast majority of firms. The reason is simple. Most firms have trivial market shares and, hence, are unable to exploit their market power. However, there is substantial variation in markups for the very largest firms that account for disproportionate shares of aggregate sales. This variation is greater under quantity competition than under price competition. In most sectors, the largest firm has a market share above 20%, which enables it to charge a markup that is 30% higher than that of the median firm under price competition and double that of the median firm under quantity competition. We use the model to undertake counterfactuals, in which we show that these variable markups for the largest firms are of quantitative relevance for aggregate welfare. Restricting firms to charge monopolistically competitive prices would raise consumer welfare by around 4% under price competition, and by around 15% under quantity competition.

Concluding remarks

Our results have a number of implications for future research.

  • First, while we show that quality is the key determinant of firm sales and firm growth, we remain agnostic on whether it is engineering, marketing, or idiosyncratic consumer preferences that explain why some products are perceived better than others.
  • Second, while there are many models of how marginal costs might vary with quality – positively, if one believes it is harder to produce high quality goods, or negatively, if one believes that better managers can better cut costs and raise quality – the data suggest that these marginal cost variations do not matter that much for firm size.

References

Aristotle (2009), The Nicomachean Ethics, Oxford World’s Classics, Oxford: Oxford University Press.

Chari, V V, P J Kehoe and E R McGrattan (2007), “Business Cycle Accounting,” Econometrica, 75(3), 781-836.

Feenstra, R C (2014), “Restoring the Product Variety and Pro-competitive Gains from Trade with Heterogeneous Firms and Bounded Productivity,” NBER Working Paper, 19833.

Hottman, C, S J Redding and D E Weinstein (2012), “What is ‘Firm Heterogeneity’ in Trade Models? The Role of Quality, Scope, Markups and Cost,” NBER Working Paper, 20436.

Manova, K and Z Zhang (2012), “Export Prices across Firms and Destinations,” Quarterly Journal of Economics, 127, 379-436.

Melitz, M J (2003), “The Impact of Trade on Intra-Industry Reallocations and Aggregate Industry Productivity,” Econometrica, 71, 1695-725.

Solow, R (1957), “Technical change and the aggregate production function,” Review of Economics and Statistics, 39(3), 312–320.

Footnote

1 This point was stressed by Aristotle in his Nicomachean Ethics (Book V, Section 5): “Demand holds things together as a single unit.... In truth it is impossible that things differing so much should become commensurate, but with reference to demand they may become so.” (see http://classics.mit.edu/Aristotle/nicomachaen.5.v.html)

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Topics:  Industrial organisation Productivity and Innovation

Tags:  firm productivity, costs of production, production quality, sales

Doctoral candidate in the Economics Department, Columbia University

Harold T. Shapiro Professor in Economics, Economics Department and Woodrow Wilson School, Princeton University; CEPR Research Fellow; NBER Programme Director

Carl S. Shoup Professor of the Japanese Economy and Associate Director of Research at the Center for Japanese Economy and Business

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